Working with Self-Employment Income
Of all of the income sources verified for affordable housing programs, self-employment income has to be one of the most challenging. There are so many factors to consider when determining income for those who are self-employed:
Types of Self-Employment Income
The first step is to determine just what sort of “self-employed” the household member is. Generally, self-employment household members are either:
- Owners of businesses
- Sub-Contractors who are paid by an employer with a 1099-form
- There are times when the individual is not sure if they are considered self-employed. Processing third party verification and additional clarification will assist in understanding if the applicant/tenant is self-employed or an independent contractor.
Is the person self-employed? Is this a new business or existing business? Did they file a tax return?
Forms certifying to self-employment can be confusing for the applicant/tenant. It is essential for management to have a thorough understanding of the forms they are required to use, and the supporting documentation is requested. Required documentation to support self-employment income varies widely, and while the following are general guidelines, you should also review your state-specific requirements.
Household Employees vs. Self-Employment
According to the IRS, applicants/tenants should be household employees if they provide services in a private residence as a housekeeper, maid, babysitter, gardener, etc. They are considered employees when the work they perform and how they perform it is in the control of the individual who hired them. Applicants in these situations would not be considered self-employed, and the employer is responsible for paying federal taxes.
However, if applicants/tenants provide these services and consider their work to be their own business (defined below), in addition to the self-employment form, request additional documentation from the individual hiring the applicant/tenant, indicating how much they pay for the services and the frequency of pay.
Per the IRS, generally, a person is self-employed if an individual:
- Carries on a trade or business as a sole proprietor or an independent contractor
- Is a member of a partnership that performs a trade or business
- Is otherwise in business for themselves (including a part-time business)
Tax Information for Self-Employed Residents
If a resident’s net earnings from their business are $400 or more, they must report this on a tax return. For residents who operate a sole-proprietorship business (or LLC, Partnership, etc), they must file a tax return regardless of whether they are reporting a profit or a loss. If an applicant/tenant states that they do not file a tax return, please check with your state agency to determine if the household should be denied admittance to your LIHTC property.
Existing Businesses vs. New Businesses
For businesses open for many years, the resident should supply two years of tax returns along with a Schedule C for each year. The applicant/tenant completes the self- employed affidavit certifying to the anticipated amount in the next 12 months. If the amount is more or less than what the tax returns support, additional documentation may be required to determine the accuracy in the certified amount.
In the case of new business, the applicant/tenant completes the self-employed affidavit certifying to the anticipated amount in the next 12 months. If possible, management should request the prior-year tax return. Management must request current copies of gross receipts (i.e., bank statements, cash receipts, customer payment logs, etc.), and an accountant statement of quarterly earnings and taxes paid, if available. It is also good to request details of expenses paid by the business.
Expenses, Exclusions, and Verifications
Management must include any salaries or other amounts distributed to family members from the business and cash or assets withdrawn by family members except when the withdrawal is a reimbursement of cash or assets invested in the business. When calculating net business income, management must not deduct principal payments on loans, interest on loans for business expansion, or outlays for capital improvements.
An applicant/tenant may use a portion of a low-income unit exclusively and regularly as a principal place of business and claim the related expenses as tax deductions, as long as the dwelling-unit is the applicant/tenant’s primary residence.
- Include this expense on a Schedule-C as an office expense.
- If the final calculation results in a negative amount, it must be included as zero on the certification.
- Appendix 3 of the 4350.3 provides the list of Acceptable Forms of Verification in the following order:
- Third-Party – Form 1040 with schedule C, E or F.
- A Financial statement(s) of business (audited or unaudited). This should include an accountant’s calculation of straight-line depreciation expense if accelerated depreciation was used on the tax return or financial statement.
- For rental property, copies of recent rent checks, lease, and receipts for expenses or IRS Schedule E.
- Provided by Applicant – Any loan application listing income derived from a business during the preceding 12 months; notarized statement showing Net Business Income.
In all cases of this type of income source, management must make a reasonable judgment as to the most accurate amount to count in the total household income. In the LIHTC industry, it is a best practice to utilize the most conservative method to calculate anticipated income. However, it is vital to review substantive evidence, if provided, to support a lower amount.